The residential property loan cost regime announced by the former chancellor in the 2015 Summer Budget has already had to be overhauled in the 2016 Finance Act, which has recently been passed. We will look at some of the changes, and some of the difficulties that taxpayers and their advisers will have to deal with when the regime starts next year. The writer confesses to having had a hand in this sorry tale, following several emails to HMRC to point out various flaws in the 2015 legislation.
Recap
The aim of the legislation is to give only 20% income tax relief for property business finance costs, insofar as the costs relate to ‘dwelling related loans’ that are progressively disallowed over the coming four tax years, in equal stages. Generally, buy-to-let (BTL) properties, houses in multiple occupation and similar are caught. This will hurt landlords who are higher or additional rate taxpayers and pay tax at more than 20% – and there will undoubtedly be more of them, once these rules start to bite, next year.
The legislation specifically excludes furnished holiday lets, and hotels and similar establishments will escape the restriction where their income is considered to derive from a trading activity, rather than a property business as per the legislation. Not being subject to income tax except in quite unusual circumstances, companies are generally outside the scope of the new regime (and even when they do pay income tax, they are basically excluded by the legislation, in almost all cases).
One of the fundamental problems with the new regime is that it tinkers with what is actually quite a long and complex process – working out your tax bill. There are officially just seven steps to a tax calculation but that is just the headline: the calculation involves numerous adjustments. Logically speaking, it is therefore quite ‘ambitious’ to introduce legislation that talks about restricting costs, reliefs, and adjustments to income and then runs around to the other end of the equation to put all that in terms of the actual amount of tax someone should end up paying.
The tax credit/reduction
One of the rules of the new regime is that, where a BTL landlord has mostly rental, interest and dividend income, the 20% tax reduction in exchange for restricting his or her mortgage interest (and related costs) will not be available to offset against any tax due on the interest or dividend income (trading income is ‘OK’). The rationale appears to be to incentivise landlords to drain their bank accounts and sell their shares, so they can pay off their BTL mortgages.
Having been at pains to reassure landlords and their advisers that they would still get tax relief for their mortgage costs, just at no more than the basic rate of 20%, I imagine it was probably quite embarrassing for HMRC to be told that actually, the legislation could quite easily end up with landlords forfeiting tax relief if, for instance, they had property losses brought forward, or current year trading losses.
The problem was with the definition of ‘adjusted total income’ in the original legislation which was, frankly, bonkers.
A far more logical and effective definition is now with us courtesy of FA 2016, and because adjusted total income is now actually adjusted (reduced) for losses, etc., there is less scope for precious finance costs that have already been disallowed, than to buy a credit against a notional amount of income that was going to be offset by losses anyway.
Unused relief ‘dying’ with the Loan
I must admit that I spotted this problem only quite late in the day, but the phrasing of the original legislation meant that it could be interpreted as preventing any carry-forward of unused finance costs relief/tax reduction once the landlord was no longer suffering the initiating disallowance of loan interest. It was a quite fine interpretation, but the consequences could have been far-reaching, meaning you would have to keep at least some mortgage interest going indefinitely, just to make sure you got all the tax relief to which you were supposed to be entitled, even if only at 20%.
The idea of on the one hand penalising BTL landlords for borrowing to finance their property businesses, while on the other requiring them to keep some mortgages going in order to get all of their corresponding tax reduction clearly made someone uncomfortable so, again, the legislation has been changed to ‘clarify’ that: ‘Any carried forward tax reduction is given in any subsequent year in which property income is received, even if there is no restriction on the deduction of finance costs in that year, for example, where the loan has been repaid.’ Which is jolly decent of them.
Note, however, that even though any unutilised tax credit may not now be forfeit just because there is no longer any mortgage interest to be disallowed, that property business must still continue: in any tax year, the amount on which tax relief is given at the basic rate cannot exceed the adjusted profits of that property business so, if that property business has ceased, that condition will collapse to nil. Many readers will be aware that HMRC is generally quite relaxed about property business cessations and commencements (see, for instance, HMRC’s Property Income manual at PIM2510) but this may not be the case going forward.
Tax relief for estates
HMRC was warned that, since trusts were subject to income tax and therefore caught by the new restrictions, they would miss out on the corresponding basic rate tax relief, because that was explicitly made available only to individuals in the legislation. The draft legislation was updated in time for the second Finance Act of 2015 but there was no provision for estates which, in terms of this legislation, fell uncomfortably between discretionary trusts and interest in possession trusts.
Finance Act 2016 now ensures that, where an estate has mortgage interest, etc., disallowed under the new regime, the beneficiaries of the estate will get a corresponding tax reduction, as and when relevant income is finally distributed to them (although I do pity whoever has to undertake the calculations, particularly where income ‘rolls up’ in the estate across several tax years).
The new legislation is at ITTOIA 2005, ss 274A, 274AA.
Conclusion: We don’t know what we don’t know
This is a brand new regime, and more problems are likely to become evident when taxpayers and advisers actually start trying to apply the new legislation to real cases. But meanwhile, a couple of points that HMRC has yet adequately to address:
- with interest in possession trusts, the regime currently seems to imply that trustees may have to take money from other beneficiaries to settle tax effectively payable on account of a life tenant’s interest in an affected property business. The life tenant will get the benefit of that tax (including potentially a tax refund), which has essentially been funded by other beneficiaries… really not how such trusts are supposed to work;
- there is some uncertainty about how, or how much of, a new loan’s finance costs should be disallowed where, for example, the loan is taken out to fund a ‘non-residential’ property acquisition – in other words, to fund a property that would not fall within the regime. The legislation seems to imply that it should be apportioned by looking at the overall property business and the mix of let dwellings (caught) to non-dwellings (not caught). But if I borrowed an extra £100,000 to fund the acquisition of my first commercial property as part of a large otherwise standard BTL portfolio, would it really be just and reasonable to deny the lion’s share of the additional interest charge, because of what I already held?
